Understanding Risk.

Before you make any decisions about what type of investment you’re looking for, it’s a good idea to identify your attitude to risk. By understanding how much risk you’re comfortable with, you can decide on the best investment for you.

Every investment carries with it the risk that you may get back less than you invest. It’s also generally accepted that the higher the potential return you'd like to achieve from your money, the higher the risk you'd need to take. So, you need to carefully consider how much risk you can afford to take (your risk capacity) against how much risk you are prepared to take (your risk tolerance), to achieve a given financial outcome (your goal) in a certain timescale (your investment time horizon).

Goals

Short-term goals are those that you plan to achieve over the next 12 months to five years. For example, you may want to pay off your credit card by the end of the year, save for a holiday next year or buy a bigger house in three years’ time.

To meet a short-term goal, you may decide to cut your spending or to set aside a certain proportion of your income each month. Any money set aside could be invested in a savings account, where the interest rate can be low but where you don’t run the risk of losing your cash.

Long-term goals are measured in timescales of five years and longer, and could involve paying for your children’s education or funding your retirement. With long-term goals, you may choose to be more adventurous in where you invest your money. By buying and holding shares, for example, there is potential for higher rewards – and time to make up losses after periods of stock market decline.

Risk capacity

Once you know what your financial goal is, you need to decide on the amount of risk that you will need to take in order to reach it. Your risk capacity could change as your personal circumstances change over time. For example, you may earn more in future.

Imagine you are saving for your children’s education and you want to invest £5,000 with a goal of reaching £50,000 after 10 years. How much risk do you need to take to achieve this? Remember, the more money you need to ‘make’, the riskier the investment, which means you may or may not reach your goal. If the stock market goes down, how much of a hit could you take and still meet your goal?

If you choose to invest in a fund that has a lower risk, there is the potential that you won't achieve your investment goal. You'll need to consider striking a balance between what you'd like to achieve and what can be achieved.

Risk tolerance

Then there’s the amount of risk that you want to take. Again, this will change as your personal financial circumstances change and over time.

How much uncertainty can you handle? Are you happy with an investment that might go up and down in value over time? If so, then you are risk-tolerant.

But if you feel upset whenever its value goes down, you’re probably risk averse. Your risk tolerance is generally higher if you feel you have more time to make up any losses in the value of your investment.

Time horizon

Your investment time horizon is the length of time before you intend to sell your investment. Do you need the money next year or in ten years’ time? If you don’t need the money for years to come, you may feel you can afford to be less conservative and to take a greater risk with your investments.

What you must remember is that your investment time horizon is always getting closer, so you need to constantly review your risk capacity and your risk tolerance. In general, the shorter your horizon, the less risk you will be willing to accept as you will want to preserve the value of your investment.